§ Debt Maturity and Covenants

§ Magnitude of agency costs depend on the maturity of debt

§ Highest for long-term debt and smallest for short-term debt

§ Debt covenants are restrictions placed by creditors on the

actions that the firm can take

§ However, covenants hinder management flexibility and have

costs of their own

§ Managers also have their own personal interests which

may differ from those of both equity and debt holders

§ Separation of ownership and control creates the possibility

of management entrenchment – facing little threat of

being fired, managers are free to run the firm in their own

best interests

§ Leverage can provide incentives for managers to run the

firm more efficiently and effectively

§ Concentration of Ownership

§ Leverage allows original owners of the firm to maintain

their equity stake – as major shareholders, they will have a

strong interest in doing what is best for the firm

§ Ross Jackson can expand his furniture store by borrowing

the funds needed, or selling 40% of the firm’s equity

§ Concentration of Ownership (cont.)

§ With debt, Ross earns $1 for every extra $1 made by the

firm

§ With equity issuance, he gains only $0.60 for every $1

increase in firm value (reduced effort)

§ With leverage, Ross will bear the full cost of perks, but will

bear only 60% of the cost with equity issuance (new equity

holders will pay 40%)

§ Concentration of Ownership (cont.)

§ Costs of reduced effort and excessive spending on perks

are another form of agency cost

§ These agency costs arise due to dilution of ownership

§ If securities are fairly priced, the original owners pay the

cost

§ Leverage can benefit the firm by avoiding these agency

costs

§ Reduction of Wasteful Investment

§ Ownership typically becomes diluted over time as a firm

grows (for large U.S. firms, most CEOs own less than 1% of

their firm’s shares)

§ With such low ownership stakes, the potential for conflict of

interest between managers and equity holders is high

§ Reduction of Wasteful Investment

§ A serious concern for large corporations is that managers

may make large, unprofitable investments – what would

motivate managers to make negative-NPV investments?

§ Empire building – managers prefer to run large firms

(higher salaries, more prestige and greater publicity) so

expand unprofitable divisions, pay too much for

acquisitions, etc.

§ Reduction of Wasteful Investment (cont.)

§ Overconfidence – believing that new opportunities are

better than they actually are, commitment to existing

investments

§ Free cash flow hypothesis – wasteful spending is more

likely to occur when firms have high levels of cash flow in

excess of what is needed to make all positive-NPV

investments and payments to debt holders

§ Reduction of Wasteful Investment (cont.)

§ According to the FCF hypothesis, leverage increases firm

value because it reduces excess cash flows and wasteful

investment

§ Leverage can also reduce the degree of managerial

entrenchment because managers are more likely to be

fired when a firm faces financial distress

§ Creditors will also monitor the managers

§ As the debt level increases, the firm benefits from the

interest tax shield and improved incentives for

management

§ If the debt level is too large, firm value is reduced due to

loss of tax benefits, financial distress costs, and the agency

costs of leverage

(Interest Tax Shield) (Financial Distress Costs)

(Agency Costs of Debt) (Agency Benefits of Debt)

V V PV PV

PV PV

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